The Fed is Breaking Things (and it could get worse)
Armchair quarterbacking the decisions of the Federal Reserve long ago became a blood sport. With the benefit of hindsight, we all are genius central bankers.
I particularly loathe managers who lay all the woes of the world at the feet of the Federal Reserve. For more than a century, America’s central bank has been a key part of the investing environment, and it’s your job as an active manager to incorporate their probable policy decisions into your strategy. Blindly heaping blame on whoever is Fed Chair is just lazy. Whenever I see the words “Financial Repression,” I translate that automatically into “manager underperformance.” The correlation is uncanny.
That said, it has become fairly obvious to any fair-minded observer that the past few years were an era where there was a rather relaxed approach to the dual mandate of the Fed. Price stability and full employment seems to have taken a back seat to asset prices, discouraging speculation, and increasing Fed Chair “credibility.”
What we got instead was a spike in inflation that was initially ignored, and then belatedly overcompensated for. The FOMC seems a little panicky; the result is the Fed is breaking things throughout the economy.
The Federal Reserve has become the bear in the China shop.
There are many errors Jerome Powell & Co. have made: First and perhaps most significant, they failed to get off of their emergency footing on a timely basis. Staying at zero far past the emergency put them in a fundamentally risky set of circumstances. Ironically, we saw a very similar error post 9/11 done by then Fed chairman Alan Greenspan. (failing to learn from history is a unique financial expertise).
They compounded that error by being way too late to recognize rising inflation. But even after they identified higher prices as a problem – CPI blew though their 2% inflation target in March 2021 – they waited way too long to respond. Given the unique circumstances of the pandemic lockdown and re-opening, perhaps we can cut them some slack for the errors.
In the attempt to play catch up, their aggressiveness is having unintended consequences. The most obvious of those unintended consequences is the sudden collapse of Silicon Valley Bank. While some are blaming specific venture capitalists for the run, it was the very rapid rise in rates that led to a $2 billion loss in treasuries and mortgage-backed securities. “Losses in U.S. Treasuries lead to difficult circumstances” is a phrase that market participants do not see all that often.
Market volatility is normal. After a 40-year bull market in bonds led by rates falling to zero, some disruptions are to be expected. But it is becoming increasingly obvious that the unprecedented sell off in bonds has been caused less by actual rates – they are historically rather modest – than by the speed at which the Fed has cranked them up.
Herein lay the problem.
Spend some time on a track piloting a vehicle at extralegal speeds, and you learn some things very quickly. The first and perhaps most important of these is “Slow is smooth, and smooth is fast.” Enter a corner too quickly, and you must slam on the brakes to avoid sliding off the track or spinning out; you exit the turn slower than someone entering more slowly and maintaining through the apex, then accelerating as they exit. A key concept you learn driving a car at high speeds is to never overreact to a problem, or you will only make it worse.
Jerome Powell and the Federal Reserve have overreacted to the inflation we saw in 2020-22. Where the 2000s-era Fed ignored obvious recklessness among banks and leveraged asset managers, the current Fed seems to be overly concerned with asset prices and appearances.
In their haste, they may be doing more damage than good.
SVB by Joshua M Brown (TRB, March 10, 2023)
Even Wealthy Landlords Are Skipping Payments on Office Buildings (Businessweek, March 9, 2023)
Ultra Easy Monetary Policy and the Law of Unintended Consequences (Dallas Fed, August 2012)
A Dozen Questions for Jerome Powell, Fed Chair (March 6, 2023)
What the Fed Gets Wrong (December 16, 2022)
Why Is the Fed Always Late to the Party? (October 7, 2022)
Transitory Is Taking Longer than Expected (February 10, 2022)
Who Is to Blame for Inflation, 1-15 (June 28, 2022)
Wealth Effect Rumors Have Been Greatly Exaggerated (November 16, 2010)